Swedroe: The Perils Of Bargain Hunting

November 18, 2016

The authors noted “the skewness of the returns of P10 is less favourable as to investors’ preferences, being skewed to the left” (that is, negatively skewed). As we observed previously, investors prefer positive skewness, as with lottery tickets. The authors also point out that their results held up to several tests of robustness.

Consumers Are Bargain Hunters

Hammerich, Fieberg and Poddig offered another interesting explanation for individual investors’ preference for low-priced stocks, providing this analogy: “Everyday consumers are trained to identify bargain buys in the (local) store as well as (and even more) on the internet.”

Thus, it seems unlikely that, due to the daily training in bargain hunting, consumers would be able to erase their inherent dispositions completely when deciding which stocks to buy.

Contributing to this bias is that stocks’ past prices serve as reference prices. They write: “Since low-priced stocks generally suffer from a bad/negative (past) momentum, past prices of low-priced stocks tend to be higher than current prices, aggravating the bargain buy illusion. On the other hand, high-priced stocks typically exhibit good/positive (past) momentum, leading to higher present prices in relation to past prices, seemingly rendering high-priced stocks a bad buy.”

Unfortunately for investors, as the authors demonstrate, expression of their preferences leads to the lower-priced stocks being relatively expensive and the higher-priced stocks being relative bargains. In addition, well-known limits to arbitrage prevent sophisticated institutional investors from correcting the mispricing.

In summary, the out-of-sample test by Hammerich, Fieberg and Poddig confirms the relevance of the nominal stock price insofar as investors’ future expectations concerning stock (performance) characteristics and investment behavior.

It also points the way toward a strategy that avoids these low-priced stocks, something that investment firms such as Dimensional Fund Advisors and Bridgeway have been doing for a long time. (In the interest of full disclosure, my firm, Buckingham, recommends Dimensional and Bridgeway funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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